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Investment, Dividend, Financing, and Production Policies: Theory and Implications

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Investment, Dividend, Financing, and Production Policies: Theory and Implications Chapter 2 Investment, Dividend, Financing, and Production Policies: Theory and Implications Abstract The purpose of this chapter is to discuss the investment and financing policy is discussed; the role of interaction between investment, financing, and dividends the financing mix in analyzing investment opportunities will policy of the firm. A brief introduction of the policy receive detailed treatment. Again, the recognition of risky framework of finance is provided in Sect. 2.1. Section 2.2 dis- debt will be allowed, so as to lend further practicality to the cusses the interaction between investment and dividends pol- analysis. The recognition of financing and investment effects icy. Section 2.3 discusses the interaction between dividends are covered in Sect. 2.5, where capital-budgeting techniques and financing policy. Section 2.4 discusses the interaction be- are reviewed and analyzed with regard to their treatment of tween investment and financing policy. Section 2.5 discusses the financing mix. In this section several numerical compar- the implications of financing and investment interactions for isons are offered, to emphasize that the differences in the capital budgeting. Section 2.6 discusses the implications of techniques are nontrivial. Section 2.6 will discuss implica- different policies on the beta coefficients. The conclusion is tion of different policies on systematic risk determination. presented in Sect. 2.7. Summary and concluding remarks are offered in Sect. 2.7. Keywords Investment policy r Financing policy r Dividend policy r Capital structure r Financial analysis r Financial 2.2 Investment and Dividend Interactions: planning, Default risk of debt r Capital budgeting r System- The Internal Versus External Financing atic risk Decision Internal financing consists primarily of retained earnings and depreciation expense, while external financing is comprised 2.1 Introduction of new equity and new debt, both long and short term. Deci- sions on the appropriate mix of these two sources for a firm This chapter discusses the three-way interaction between in- are likely to affect both the payout ratio and the capital struc- vestment, financing, and dividend decisions. As shown in fi- ture of the firm, and this in turn will generally affect its mar- nancial policy literature, there exists a set of ideal conditions ket value. In this section an overview of internal and external under which there will be no interaction effects between the financing is provided, with the discussion culminating in a areas of concern. However, the ideal conditions imposed by summary of the impacts that earnings retention or earnings academicians to analyze the effects dividend and financing payout (with or without supplemental financing from exter- policy have on the investment decision and the value of the nal sources) can have on a firm’s value and on planning and firm are not realistic, when one considers financial manage- forecasting. ment in the real world. Thus, an overview of the interactions of financing, investment, and dividend decisions is important for those concerned with financial analysis and planning. This chapter sequentially addresses the three interaction Internal Financing effects. In Sect. 2.2 the relation between investment and div- idend policy is explored through a discussion of internal vs. Changes in equity accounts between balance-sheet dates are external financing, with the emphasis on the use of retained generally reported in the statement of retained earnings. earnings as a substitute for new equity, or vice versa. The Retained earnings are most often the major internal source interaction between corporate financing and dividend poli- of funds made available for investment by a firm. The cost of cies will be covered in Sect. 2.3, where default risk on debt these retained earnings is generally less than the cost associ- is recognized. Then in Sect. 2.4, the interaction between ated with raising capital through new common-stock issues. C.-F. Lee et al. (eds.), Handbook of Quantitative Finance and Risk Management, 23 DOI 10.1007/978-0-387-77117-5_2, c Springer Science+Business Media, LLC 2010 24 2 Investment, Dividend, Financing, and Production Policies: Theory and Implications Table 2.1 Payout ratio – 1962 0.58 1974 0.405 1986 0.343 1998 0.234 composite for 500 firms 1963 0:567 1975 0:462 1987 0:559 1999 0.435 1964 0:549 1976 0:409 1988 0:887 2000 0.299 1965 0:524 1977 0:429 1989 0:538 2001 0.383 1966 0:517 1978 0:411 1990 0:439 2002 0.04 1967 0:548 1979 0:38 1991 0:418 2003 0.259 1968 0:533 1980 0:416 1992 0:137 2004 0.311 1969 0:547 1981 0:435 1993 0:852 2005 0.282 1970 0:612 1982 0:422 1994 0:34 2006 0.301 1971 0:539 1983 0:399 1995 0:346 1972 0:491 1984 0:626 1996 0:327 1973 0:414 1985 0:525 1997 0:774 It follows that retained earnings, rather than new equity, financing will have different effects on the growth rate of should be used to finance further investment if equity is to be earnings per share, of dividends per share, and, presumably, used and the dividend policy (dividends paid from retained of the share price itself. earnings) is not seen to matter. The availability of retained Higgins (1977) considered the amount of growth a firm earnings is then determined by the firm’s profitability and could maintain if it was subject to an external equity con- the payout ratio, the latter being indicative of dividend pol- straint and sought to maintain certain debt and payout ratios. icy. Thus we find that the decision to raise funds externally He was able to show the sustainable growth rate in sales, S, may be dependent on dividend policy, which in turn may af- to be: fect investment decisions. p.1 d/.1 C L/ .rr/.ROE/ The payout ratios indicated in Table 2.1 show that, on av- SD D (2.1) erage, firms in the S&P 500 retained more than 50% of their t p.1 d/.1 C L/ 1 .rr/.ROE/ earnings after 1971 rather than pay them out in dividends. where p, profit margin on sales; d, dividend payout ratio; L, This is done because of the investment opportunities avail- debt-to-equity ratio; t, total asset-to-sales ratio; rr, retention able for a firm, and indicates that retained earnings are a ma- rate; ROE, return on equity. jor source of funds for a firm. Higgins (1977) used 1974 U.S. manufacturing firms’ composite financial statement data as an example to calculate S . Using the figures p D 5:5%;d D 33%;L D 88%and External Financing t D 73%, he obtained: .0:055/.1 0:33/.1 C 0:88/ External financing usually takes one of two forms, debt SD D 10:5% 0:73 .0:055/.1 0:33/.1 C 0:88/ financing or equity financing. We leave the debt vs. equity question to subsequent sections, and here directly confront Using this method we can calculate sustainable growth rate only the decision whether to utilize retained earnings or new in sales for financial analysts and planning models. common stock to finance the firm. From this we can see that a firm with many valuable in- We have previously shown that the market value of the vestment opportunities may be forced to forego some of these firm is unaffected by such factors if dividend policy and cap- opportunities due to capital constraints, and the value of the ital structure are irrelevant. It should also be clear that div- firm will not be maximized as it could have been. Dividend idend policy and capital structure can affect market values. and capital-structure decisions relate directly to investment Therefore, the consideration of an optimal internal-external decisions. While it may not be reasonable to assume that the financing combination is important in the field of financial firm could not issue new equity, the question is at what cost management. This optimal combination is a function of the it can be raised under such a constraint. payout ratio, the debt-to-equity ratio, and the interaction be- In an even more practical vein, Higgins also incorpo- tween these two decision variables. From this it can be shown rated inflation into his model, acknowledging the fact that (and this will be the topic of discussion in the following para- most depreciation methods that serve to make depreciation a graphs) that different combinations of internal and external source of funds are founded on historical costs, and not the 2 Investment, Dividend, Financing, and Production Policies: Theory and Implications 25 replacement values the firm must pay to sustain operations taining a high payout rate and financing further investment at their current level. Introducing the new variables defined with new-equity issues. below, it is possible to define sustainable growth in real and nominal terms, the former being the item of interest here. Let c, nominal current assets to nominal sales; f, nominal 2.3 Interactions Between Dividend fixed assets to real sales; j, inflation rate. and Financing Policies So real sustainable growth Sr is If we were able to hold the capital structure of firms con- .1 C j/p.1 d/.1 C L/ jc S D : stant, then we would be able to determine the advantage or r .1 C j/c C f .1 C j/p.1 d/.1 C L/ (2.2) disadvantage of internal financing relative to external financ- ing. Van Horne and McDonald, as briefly mentioned before, Using figures from the manufacturing sector and an inflation were able to empirically test for the effects created by ei- rate of 10%, which at the time of writing was approximately ther policy, providing the substance for a major part of the the actual inflation rate then prevailing, it was found that following discussion.
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